Investment, Saving, and the Real Interest Rate

Investment, Chapter Saving, and the Real Interest ANSWERS TO CHECKPOINTS 26  CHECKPOINT 26.1 Physical Capital and Financial Capital 1. Annie runs a fitness center. On December 31, 2007, she bought an existing business with exercise equipment and a building worth $300,000. During 2008, business was poor, so she sold some of her equipment for $100,000. What was Annie’s gross investment, depreciation, and net investment during 2008? What was the value of Annie’s capital at the end of 2008? Annie’s gross investment during 2008 was $100,000 because she sold some of her capital. Annie’s depreciation during 2008 was 0. Annie’s net investment during 2008 was $100,000, which equals gross investment ($100,000) minus depreciation ($0). Anne’s capital equals her capital at the beginning of 2008, $300,000, plus her net investment in 2008, $100,000, so her capital at the end of 2008 was $200,000. 2. Karrie is a golf pro, and after she paid taxes, her income from golf and from stocks and bonds was $1,500,000 in 2008. At the beginning of 2008, she owned $900,000 worth of stocks and bonds. At the end of 2008, Kar- rie’s stocks and bonds were worth $1,900,000. How much did Karrie save during 2008 and how much did she spend on consumption goods and services? Karrie’s wealth increased by $1,000,000 in 2008. So her saving in 2008 was $1,000,000. (This point assumes no capital gains or losses on her stocks and bonds.) Her income after taxes was $1,500,000. Her consumption equals her income minus her saving, which is $1,500,000  $1,000,000 = $500,000. 210 Part 8 . THE REAL ECONOMY

 CHECKPOINT 26.2 The Market for Loanable Funds In 2008, the Lee family had a disposable income of $80,000, wealth of $140,000, and an expected future income of $80,000 a year. At a real interest rate of 4 percent a year, the Lee family saves $15,000 a year; at a real interest rate of 6 percent a year, they save $20,000 a year; and at a real interest rate of 8 percent, they save $25,000 a year. Use this information to answer Exercises 1 and 2. 1. Draw a graph of the Lee family’s supply of loanable funds curve. The graph illustrating the Lee family’s supply of loanable funds curve is in Figure 26.1. 2. In 2009, suppose that the stock market crashes and the Lee family’s wealth decreases by 50 percent. Explain how this decrease in wealth influences the Lee family’s supply of loanable funds curve. If the stock market crashes so that the Lee family’s wealth decreases, then the Lee family will increase its saving. As a result, the Lee family’s supply of loanable funds increases and its supply of loanable funds curve shifts rightward. 3. Draw graphs that illustrate the effect of an increase in the demand for loanable funds and an even larger increase in the supply of loanable funds on the real interest rate and the equilibrium quantity of loanable funds. The increase in the demand for loanable funds raises the real interest rate and increases the equilibrium quantity of loanable funds. The increase in the supply of loanable funds lowers the real interest rate and increases the equilibrium quantity of loanable funds. If the change in the supply of loanable funds exceeds the change in the demand for loanable funds, the real interest rate falls. Both changes increase the equilibrium quantity of loanable funds, so the equilibrium quantity of loanable funds increases. Figure 26.2 illustrates this situation. The increase in the demand for loanable funds shifts the demand for loanable funds curve right- Chapter 26 . Investment, Saving, and the Real Interest Rate 211

ward from DLF0 to DLF1. The increase in the supply of loanable funds

shifts the supply of loanable funds curve rightward from SLF0 to SLF1. As Figure 26.2 shows, the real interest rate falls, from 6 percent a year to 5 percent a year. The equilibrium quantity of loanable funds increases, from $11 trillion to $13 trillion.  CHECKPOINT 26.3 Government in Loanable Funds Market In the loanable funds market set out in the Real Loanable Loanable table, the demand for loanable funds in- interest funds funds creases by $1 trillion at each real interest rate demanded supplied rate and the private supply of loanable (percent (trillions of 2000 dollars per funds increases by $2 trillion at each inter- per year) year) est rate. 4 8.5 5.5 1. If the government budget is balanced, 5 8.0 6.0 6 7.5 6.5 what are the real interest rate, the quan- 7 7.0 7.0 tity of loanable funds, investment, and 8 6.5 7.5 private saving? Is there any crowding 9 6.0 8.0 out in this situation? 10 5.5 8.5 The real interest rate is 6 percent, and the quantity of loanable funds, private saving, and investment are all $8.5 trillion. There is no crowding out. 2. If the government budget deficit is $1 trillion, what are the real interest rate, the quantity of loanable funds, investment, and private saving? Is there any crowding out in this situation? The equilibrium real interest rate becomes 7 percent. The equilibrium quantity of loanable funds is $8.0 trillion, the equilibrium quantity of investment is $8.0 trillion, and the equilibrium quantity of private saving is $9.0 trillion. There is crowding out of $500 billion of investment. 3. If governments want to stimulate the quantity of investment and increase it to $9 trillion, what must they do? Assuming no Ricardo-Barro effect, the government needs to have a budget surplus of $1 trillion. In this case, the new equilibrium is at a real interest rate of 5 percent, the quantity of investment is $9 trillion, and the quantity of private saving is $8 trillion. 212 Part 8 . THE REAL ECONOMY

ANSWERS TO CHAPTER CHECKPOINT  Problems 1. On January 1, 2006, Terry’s Towing Service owned 4 tow trucks valued at $300,000. During 2006, Terry’s bought 2 new trucks for a total of $180,000. At the end of 2006, the market value of all the firm’s trucks was $400,000. What was Terry’s gross investment, depreciation, and net investment? His gross investment was $180,000. His depreciation was $80,000. His net investment, which is equal to gross investment minus depreciation, was $100,000. The Bureau of Economic Analysis reported that the U.S. capital stock was $23.0 trillion at the end of 1999, $23.8 trillion at the end of 2000, and $24.4 trillion at the end of 2001. Depreciation in 2000 was $1.0 trillion, and gross investment during 2001 was $1.6 trillion (all in 1996 dollars). Use this information to answer Problems 2 and 3. 2. Calculate U.S. net investment and gross investment during 2000. Net investment equals the change in the capital stock. So in 2000, U.S. net investment was $23.8 trillion  $23.0 trillion, which is $0.8 trillion. Gross investment equals net investment plus depreciation. So in 2000, U.S. gross investment was $0.8 trillion + $1.0 trillion, which is $1.8 trillion. 3. Calculate U.S. net investment and depreciation during 2001. Net investment equals the change in the capital stock. So in 2001, U.S. net investment was $24.4 trillion  $23.8 trillion, which is $0.6 trillion. Depre- ciation equals gross investment minus net investment. So in 2001, U.S. depreciation was $1.6 trillion  $0.6 trillion, which is $1.0 trillion. 4. Mike takes a summer job washing cars. During the summer, he earns an after-tax income of $3,000 and he spends $1,000 on goods and services. What was Mike’s saving during the summer and the change, if any, in his wealth? Mike’s saving is equal to his after-tax income minus his consumption expenditure, which is $3,000  $1,000 =$2,000. Mike’s wealth increased by the amount of his saving, $2,000. 5. What is the market for financial capital? What is financial capital? Is the market for financial capital a national market or a global market? Financial markets are the collection of households, firms, governments, banks, and other financial institutions that lend and borrow. Financial markets include the stock market, the bond market, the short-term securities market, and the market for loans. Financial assets, such as stocks, bonds, and short-term securities are traded in financial markets. The global financial market determines the real interest rate. Chapter 26 . Investment, Saving, and the Real Interest Rate 213

6. Explain why when the real interest rate rises, the demand for loanable funds does not change but the quantity of funds demanded decreases. An increase in the real interest rate leads to a movement upward along the demand for loanable funds curve The demand for loanable funds curve does not shift. The quantity of loanable funds demanded decreases. The factor that changes the demand for loanable funds, that is, changes the entire relationship between the real interest rate and the quantity of loanable funds demanded is the expected rate of profit. When the expected rate of profit changes, the demand for loanable funds changes and the loanable funds demand curve shifts. 7. A new technology is developed that increases firms’ expected profit. Draw a graph to show the effect of this development on the market for loanable funds. What are the effects of this development on the equilibrium real interest rate and investment? New technology that increases the expected rate of profit increases investment demand. The increase in the demand for investment increases the demand for loanable funds. As a result, the demand for loanable funds curve shifts rightward. Figure 26.3 shows this change as the shift in the demand for loanable

funds curve from DLF0 to DLF1. The increase in the demand of loanable funds raises the real interest rate, in Figure 26.3 from 5 percent to 6 percent. Figure 26.3 also shows that the increase in the demand for loanable funds increases the equilibrium amount of loanable funds, in the figure from $10 trillion to $12 trillion. Equivalently, the equilibrium quantity of saving and investment increase from $10 trillion to $12 trillion. 8. During the 1990s, the invention and use of fiber-optic technologies re- quired billions of dollars to be spent laying new cables under the oceans and launching communications satellites. Explain, using a graph, the effect of this event on the market for loanable funds. The invention and use of fiber optics in the 1990s decade lead to an increase in investment demand. The increase in investment demand increases the demand for loanable funds so that the demand curve for loanable funds shifts rightward. Figure 26.4 (on the next page) shows this

change as the shift in the demand for loanable funds curve from DLF0 to

DLF1. The increase in the demand for loanable funds raises the equilibri- 214 Part 8 . THE REAL ECONOMY

um real interest rate and increases the equilibrium quantity of loanable funds. In Figure 26.4, the equilibrium real interest rate rises from 5 percent to 6 percent and the equilibrium quantity of loanable funds increases from $10 trillion to $12 trillion. The increase in the equilibrium quantity of loanable funds means that the equilibrium quantity of saving and investment also increase, in Figure 26.4 from $10 trillion to $12 trillion. 9. With an increase in global tension during 2005 and 2006, many governments increased de- fense spending, which decreased government budget surpluses. Show, on a graph, the effects of a decrease in government budget surpluses if there is no Ricardo-Barro effect. Ex- plain how the effects differ if there is a partial Ricardo-Barro effect. Figure 26.5 shows the initial private supply of

loanable funds curve, PSLF0 and the initial to-

tal supply of loanable funds curve, SLF0. The horizontal difference between the two curves, indicated by the arrow, is the amount of the initial government budget surpluses. If the governments begin to run smaller budget surpluses and there is no Ricardo-Barro effect, the private supply of loanable funds

curve remains the same, PSLF0. The total supply of loanable funds curve shifts leftward, in

the figure to SLF1. If the demand for loanable funds does not change, in equilibrium the real interest rate will rise and the quantity of investment will decrease. If the governments begin to run smaller budget surpluses and there is a full Ricardo-Barro effect, the total supply of

loanable funds curve remains the same, SLF0. The private supply of loan-

able funds curve shifts rightward to PSLF1 because households increase their saving to offset the lessened government saving. If the demand for loanable funds does not change, in equilibrium the real interest rate will not change and the quantity of investment will not change. Chapter 26 . Investment, Saving, and the Real Interest Rate 215

If there is a partial Ricardo-Barro effect, the effects are partway between those with no Ricardo-Barro effect and a full Ricardo-Barro effect. The private supply of loanable funds curve shifts rightward but not all the way

to PSLF1 and the total supply of loanable funds curve shifts leftward but

not all the way SLF1. IMF Warning Over Slowing Growth The global economy may face a marked slowdown next year as a result of the turmoil in financial markets, the International Monetary Fund has warned. The IMF said the global credit squeeze would test the ability of the economy to continue expanding at recent rates. While future economic stability could not be taken for granted, there was plenty of evidence that the global economy remained durable, it added. BBC News, October 10, 2007 Use this information to answer Problems 10 and 11. 10. Explain how turmoil in global financial markets might effect the demand for loanable funds, investment, and global economic growth in the future. The turmoil in financial markets might lead some people to decrease their saving because of fear that they might lose these funds due to the turmoil. As a result, the supply of loanable funds might decrease, which would push up the real interest rate. The primary source demanding loanable funds is business firms who demand these funds to make investment. If the real interest rate rises, the quantity of loanable funds demanded will decrease as businesses cancel no-longer profitable investments. With less investment there will be less capital and so the growth in potential GDP will slow. 11. What might be the evidence that the global economy will continue to grow? Growth will remain if investment continues to be robust. Investment de- pends on the real interest rate and the expected profit rate. At the time of the report, there seemed to be little sign that the “global credit squeeze” was resulting in a sharply higher real interest rate, which could serve to decrease investment. The historical evidence is that the demand for and supply of loanable funds increase at about the same rate, so there is no trend in the real interest rate and the IMF’s report does not explicitly men- tion a higher real interest. It also is likely that profit expectations have not plummeted. Survey data could be used to try to get a read on profit expectations. But perhaps more objectively, GDP continued to expand at a reasonably fast clip in many countries and this relatively rapid expansion likely increased future profit opportunities. 216 Part 8 . THE REAL ECONOMY

 Exercises 1. On January 1, 2007, Sophie’s Sunlounge owned 4 tanning beds valued at $20,000. During 2007, Sophie’s bought 3 new beds at a total cost of $12,000, and at the end of the year, the market value of all of Sophie’s beds was $26,000. What was Sophie’s gross investment, depreciation, and net investment? Her gross investment was $12,000 for the new beds. Her net investment is the difference in the value of the capital over the year and is $6,000. De- preciation equals gross investment minus net investment, so her depreciation was $6,000. 2. The numbers in the second col- Wealth Saving umn of the table are the Federal (billions of (billions of Reserve’s estimates of the per- Year 1996 dollars) 1996 dollars) sonal wealth at the end of each 1998 35,681 292 year. The numbers in the third 1999 39,810 154 column are the Bureau of Eco- 2000 38,353 63 nomic Analysis’s estimates of 2001 36,450 108 personal saving each year. In which years did the change in wealth exceed saving? In which years did saving exceed the change in wealth? Given the definitions of saving and wealth, how can the change in wealth differ from saving? The change in wealth exceeded the change in saving in 1998 and 1999. Saving exceeded the change in wealth in 2000 and 2001. The change in wealth can exceed saving if the prices of the assets included in wealth increase during the year. In other words, the change in wealth can exceed the change in saving if there are capital gains. 3. Cindy takes a summer job painting houses. During the summer, she earns an after-tax income of $5,000 and she spends $2,000 on living ex- penses. What was Cindy’s saving during the summer and the change, if any, in her wealth? Cindy’s saving is equal to her after-tax income minus her consumption expenditure, which is $5,000  $2,000 =$3,000. Cindy’s wealth increased by the amount of her saving, $3,000. 4. Explain the effect on the supply of loanable funds of an increase in wealth, an increase in future income, and a cut in current income taxes. The greater the wealth a household has accumulated, other things remaining the same, the less it will save. The reason is that the household already has assets to draw upon to consume. Private saving supply decreases so the supply of loanable funds decreases. The higher a household’s expected future income, other things remaining the same, the smaller is its saving. The reason is that the household will Chapter 26 . Investment, Saving, and the Real Interest Rate 217

prefer to consume more now knowing it can save more later when its disposable income is expected to rise. Private saving supply decreases so the supply of loanable funds decreases. A cut in current income taxes increases disposable income in the present. This change increases private saving supply and so increases the supply of loanable funds. 5. During the 1990s, a stock market boom increased wealth by trillions of dollars. Explain the effect of this boom on the equilibrium real interest rate in the global financial market and on global investment and global saving. The increase in wealth decreased people’s saving and thereby decreased the supply of loanable funds. The decrease in the supply of loanable funds raised the equilibrium real interest and decreased the equilibrium quantity of loanable funds. The equilibrium quantity of investment and saving also decreased. During the late 1990s, governments around the world had large budget deficits. In the early 2000s, government budget deficits began to turn into surpluses. Use this information to answer Exercises 6 and 7. 6. Show, on your graph, the effects of a switch from a government budget deficit to a government budget surplus if there is no Ricardo-Barro effect. Figure 26.6 shows the initial private saving

supply curve as PSLF0 and the initial total

saving supply curve as SLF0. The horizontal difference between the two curves, indicated by the arrow, is the amount of the initial government budget deficits. If the governments begin to run budget surpluses and there is no Ricardo-Barro effect, the private saving curve

remains the same, PSLF0. The total saving

supply curve shifts rightward to SLF1. 7. What are the effects of a switch from a government budget deficit to a government budget surplus if there is a partial Ricardo-Barro effect. If the governments begin to run budget surpluses and there is no Ricardo-Barro effect, the total supply of loanable funds increases. In Figure 26.6, the total supply of

loanable funds curve shifts rightward from to SLF0 to SLF1 so that in equilibrium the real interest rate falls and investment increases. If the governments begin to run budget surpluses and there is a total Ricardo-Barro ef- 218 Part 8 . THE REAL ECONOMY

fect, the total supply of loanable funds does not change so that the supply

of loanable funds curve remains SLF0. (The private supply of loanable funds, saving, decreases one-to-one with the increase in government saving so the private supply of loanable funds curve shifts leftward to

PSLF1.) In equilibrium, the real interest rate does not change and investment does not change. If the governments begin to run budget surpluses and there is a partial Ricardo-Barro effect, the effects will be between the two extreme cases discussed above: the total supply of loanable funds

curve shifts rightward (but not all the way to SLF1) and the private supply

of loanable funds curve shifts leftward (but not all the way to PSLF1.) In the equilibrium, the real interest falls, but not by as much as in the case with no Ricardo-Barro effect and investment increases, but not by as much as in the case with no Ricardo-Barro effect. Greenspan’s Conundrum Spells Confusion for Us All …At the beginning of the year, the consensus was that … bond yields would rise ... Gradually, over February, the consensus has started to reassert itself. … Ten-year Treasury bond yields were hovering below 4 percent in the early part of the month but now they are around 4.3 percent. Because the consensus was that bond yields should be 5 percent by the end of the year, most commentators have focused, not on why bond yields have suddenly risen, but on why they were so low before. A number of explanations for this “conundrum” have been advanced. First, bond yields are being held artificially low by unusual buying. … An- other [is that] ... bond yields reflect investors’ expectations for an economic slowdown in 2005. Philip Coggan, Financial Times, February 26, 2005 Use this information and the loanable funds market to answer Exercises 8 and 9. 8. Explain how “unusual buying” might lead to a low real interest rate. “ Unusual buying” means that the demand in the financial market for bonds is “unusually” large. In this case, the unusually large demand will lead to bond prices being unusually high. Higher bond prices mean a lower interest rate on the asset. So unusually high bond prices will create unusually low interest rates on bonds. 9. Explain how “investors’ expectations for an economic slowdown” might lead to a low real interest rate. Investors expectations of an economic slowdown mean that the expected profit from investing in capital falls. The lower expected profit rate decreases the demand for investment, which decreases the demand for loan- Chapter 26 . Investment, Saving, and the Real Interest Rate 219

able funds. The fall in the demand for loanable funds then lowers the equilibrium real interest rate.  Critical Thinking and Web Activities 1. Look at the data provided in Eye on the U.S. Economy on page 663. a. What fluctuates most and why: net investment, gross investment, depreciation, or capital? Net investment fluctuates the most because it increases during expan- sions and decreases during recessions. b. Why do you think net investment surged upward so strongly during the 1990s? Net investment surged upward because of major investments made in the Internet and telecommunications sectors of the economy. In ad- dition, Y2K fears lead many firms to invest in new computer equipment in the late 1990s. c. How might you set about determining whether the swings in net investment were changes in investment demand or changes in the quantity of investment? One way to determine if the swings in net investment are due to changes in investment demand or changes in the quantity of investment would be to look at the real interest rate. An increase in investment demand leads to a higher real interest while an increase in the quantity of investment is the result of a lower real interest rate. d. Can you think of ways in which the fluctuations in investment might be smoothed? Investment can be smoothed by smoothing the real interest rate. It can also be smoothed by government policy that taxes investment if it surges upward and subsidizes investment if it plummets. e. Do you think it would it be a good idea or a bad idea to smooth the fluctuations? Why? There seems no particularly good reason to believe that smoothing investment is a good idea. Each individual firm has the most accurate assessment of how much investment it needs to undertake, so investment probably ought to be left alone. 220 Part 8 . THE REAL ECONOMY

2. China, India, and Indonesia account for about half the world’s popula- tion and are expanding at a rapid rate. Do these countries lend to or borrow from the United States? As these countries become wealthier and more similar to the United States, how do you think they will affect the global market for financial capital? Would you expect the real interest rate to rise, fall, or remain close to its current level? Why? Currently these nations lend to the United States. As these economies become wealthier, world demand for loanable funds (for investment) and world supply of loanable funds (from saving) increase. Probably the two effects are of similar magnitude, so the real interest will remain close to its current level. If, however, investment opportunities increase in these countries or if their people begin to emulate U.S. residents by saving less, then the real interest rate will rise. 3. During 2001, the Commerce Department reported that the U.S. saving rate was negative. How can the saving rate be negative? Why might a negative saving rate be something to worry about? How do you think saving in the United States could be stimulated? Saving can be negative if people, on net, are borrowing, in this case from foreigners. A negative saving rate can be worrisome because at some point the borrowing must be repaid. If the borrowing is used to finance consumption expenditure, it will be more difficult to repay the loans. Sav- ing can be stimulated using government policies. For instance, the government could decrease or eliminate taxes on interest income or gains in the stock market. 4. Visit the Web sites of the New York Stock Exchange, the London Stock Exchange, and PACIFIC. a. Find a stock that trades on both exchanges and obtain its current price in New York and London. Your students’ answers will vary and depend on the stock they select. b. Find today’s exchange rate between the U.S. dollar and the U.K. pound. Your students’ answers will vary and depend on the stock they select. c. Use today’s exchange rate to convert the London price to U.S. dollars. Your students’ answers will vary and depend on the stock they select. d. What is the difference in the two prices? Could you earn a profit by buying in one market and selling in the other? The one common feature among your students’ answers is that it should not be possible to earn a profit. Any profit that they might think is present is almost surely the result of prices and/or the exchange rate being for different times. Chapter 26 . Investment, Saving, and the Real Interest Rate 221

e. Why do you think the prices are so similar in the two stock markets? The fact that no profit can be earned because the prices are so similar reflects the point that the financial markets are a global market. 5. Open the file that provides data on saving rates in the United States and the new industrial economies of East Asia. a. Which of the countries has the highest saving rate and which has the lowest? The saving rate in East Asia averages near 30 percent. The saving rate in the United States averages near 20 percent. The saving rate is much higher in the Asian economies. b. Of the factors that influence saving, do you think the differences across these economies represent differences in the supply of saving or differences in the quantity of saving supplied? Explain your answer. The difference is most likely a difference in the supply of saving. The differences in the saving rates would be a difference in the quantity of saving supplied only if the real interest rate was different in East Asia than in the United States. The real interest rates in these countries are probably similar because of the global financial market so the difference is due to a difference in the supply of saving. c. Of the influences on the supply of saving, which do you think might account for the differences in saving rates that you’ve found? Government saving in the Asian nations is always higher than that in the United States, which accounts for part of the difference between the saving rates. However, it is not all the difference because private saving in the Asian nations is also larger. Of the three factors that affect saving discussed in the text, the most likely variable that leads Asian saving to be larger than U.S. saving is wealth, which will be less in the Asian nations. Alternatively, there might be cultural differences that favor more saving in Asian nations as well as more government programs designed to increase saving in the Asian nations. 222 Part 8 . THE REAL ECONOMY

ADDITIONAL EXERCISES FOR ASSIGNMENT

 Questions  CHECKPOINT 26.1 Physical Capital and Financial Capital 1. Comment on the following statement: “A person can only increase his or her wealth by acquiring more goods and services.” 2. Annie runs a fitness center. On December 31, 2007, she bought an existing business with exercise equipment and a building worth $600,000. During her first year of operation, business was poor. She sold some of her equipment to a competitor for $200,000. 2a. What was Annie’s gross investment during 2008? 2b. What was Annie’s depreciation during 2008? 2c. What was Annie’s net investment during 2008? 2d. What was the value of Annie’s capital at the end of 2008? 3. Karrie is a golf pro, and after she paid taxes, her total income from golf and from the stocks and bonds that she owns was $1,000,000 in 2008. At the beginning of 2008, she owned $600,000 worth of stocks and bonds. At the end of 2008, Karrie's stocks and bonds were worth $1,400,000. How much did Karrie save during 2008 and how much did she spend on consumption goods and services?  CHECKPOINT 26.2 The Market for Loanable Funds 4. Determine whether the following changes in the demand for loanable funds and the supply of loanable funds will raise the real interest rate, lower the real interest rate, leave the real interest rate unchanged, or have an ambiguous effect on the real interest rate: 4a. Increase in the supply and an increase in the demand. 4b. Increase in the supply and a decrease in the demand. 4c. Decrease in the supply and a decrease in the demand.  CHECKPOINT 26.3 Government in Loanable Funds Market 5. Starting from the situation in Real interest Investment Private saving the table, investment demand rate (trillions of 2000 dollars per year) increases by $2 trillion at each (percent per level of the real interest rate and year) the supply of private saving in- 4 8.5 5.5 creases by $1 trillion at each interest rate. 5 8.0 6.0 5a. If the government budget has 6 7.5 6.5 neither a surplus nor a deficit, 7 7.0 7.0 what are the real interest rate, the quantity of investment, and 8 6.5 7.5 9 6.0 8.0 10 5.5 8.5 Chapter 26 . Investment, Saving, and the Real Interest Rate 223

the quantity of private saving? Is there any crowding out in this situation? 5b. If the government budget deficit is $1 trillion, what are the real interest rate, the quantity of investment, and the quantity of private saving? Is there any crowding out in this situation? 5c. If governments want to stimulate the quantity of investment and increase it to $10 trillion, what must they do? 6. Assume the government initially has a balanced budget. Next year the government runs a $50 billion deficit. If the quantity of investment remains the same, what other change must have occurred in this economy? (Hint: Use the identity in Checkpoint 26.3 to answer this question.) What effect was discussed in the chapter that sounds remarkably similar to the answer that you provided?  Answers  CHECKPOINT 26.1 Physical Capital and Financial Capital 1. The statement is false. A person’s wealth is the value of all the things that the person owns. Saving, which is the amount of income that is not paid in taxes or spent on consumption goods and services adds to wealth. But wealth also increases when the value of assets rises—called capital gains. 2a. Annie’s gross investment during 2008 was $200,000 because she sold some of her capital. 2b. Annie’s depreciation during 2008 was $0. 2c. Annie’s net investment during 2008 was $200,000, which equals gross investment ($200,000) minus depreciation ($0). 2d. Anne’s capital at the end of 2008 equals her capital at the beginning of 2007, $600,000, plus her net investment in 2008, $200,000, so her capital at the end of 2008 was $400,000. 3. Karrie’s wealth increased by $400,000 in 2008. So her saving in 2008 was $400,000. (This point assumes no capital gains or losses on her stocks and bonds.) Her income after taxes was $1,000,000. Her consumption expenditure equals her income minus her saving, which is $1,000,000  $400,000, $600,000.

 CHECKPOINT 26.2 The Market for Loanable Funds 4a. The effect on the real interest rate is ambiguous because we do not know the relative magnitudes of the changes. An increase in the supply of loanable funds, other things being equal, lowers the real interest rate. However, other things being equal, an increase in the demand for loanable funds raises the real interest rate. The net effect is ambiguous. 4b. The real interest rate will fall. The result is clear because both changes lower the real interest rate. 224 Part 8 . THE REAL ECONOMY

4c. The effect on the real interest rate is ambiguous because we do not know the relative magnitudes of the changes. A decrease in the supply of loanable funds, other things being equal, raises the real interest rate. However, other things being equal, a decrease in the demand for loanable funds lowers the real interest rate. The net effect is ambiguous.

 CHECKPOINT 26.3 Government in Loanable Funds Market 5a. The real interest rate is 8 percent a year, and the quantity of private saving and investment are both $8.5 trillion. There is no crowding out. 5b. The real interest rate is now 9 percent a year, the quantity of investment is $8.0 trillion and the quantity of private saving is $9.0 trillion. There is crowding out of $500 billion of investment. 5c. Assuming no Ricardo-Barro effect, the government would need to have a budget surplus of $3 trillion. In this case, the new equilibrium would be at a real interest rate of 5 percent a year, the quantity of investment would be $10 trillion, and the quantity of private saving would be $7 trillion. 6. The following identity can help us answer this question: I = S + (NT  G). If initially there is a balanced budget, then NT and G are equal. That means that initially I = S. Now, if the government runs a budget deficit of $50 billion, then NT  G is negative (and equal to negative $50 billion). If investment remains unchanged, then the formula shows that the only adjustment that could be made is if somehow private saving increased by $50 billion. The increase in the government budget deficit leading to a similar sized increase in private saving is the Ricardo-Barro effect discussed in the chapter.